5/24/11

Under the case of high inflation, aggregate demand (AD) is too far right, and the government wants to shift it left. One of its tools is monetary policy, which it can use to set the federal funds rate by buying and selling T-bills in the market. If the Fed wants to lower inflation, they will want to set the federal funds rate higher, the way they do this is by selling T-Bills. This means that people/businesses in the market exchange their money for these bonds.

Now people/businesses have bonds instead of money, so there is less money available to use and/or loan. This lowering of the money supply causes interest rates to rise, which cuts spending (because of higher motivation to save due to higher interest rates).

The goal of using this tool is to keep inflation low. Generally high inflation is considered a bad things because money today is not worth as much as money in the future. Under very high inflation rates an economy will run into costs not associated with a low inflation economy these include menu costs (re-ordering menus/catalogs), or contract costs (no one is willing to sign a long term contract, or give long term loans).